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Discounted cash flow#Shortcomings

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"Commercial banks have widely used discounted cash flow as a method of valuing commercial real estate construction projects. This practice has two substantial shortcomings. 1) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically, over time, and 2) straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually last fewer than ten years. Using DCF to analyze commercial real estate during any but the early years of a boom market will lead to overvaluation of the asset.[citation needed]

Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple perpetuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on involves calculating the period of time likely to recoup the initial outlay.

Another shortcoming is the fact that the Discounted Cash Flow Valuation should only be used as a method of intrinsic valuation for companies with predictable, though not necessarily stable, cash flows. The Discounted Cash Flow valuation method is widely used in valuing mature companies in stable industry sectors such as Utilities. At the same time, this method is often applied to valuation of high growth technology companies. In valuing young companies without much cash flow track record, the Discounted Cash Flow method may be applied a number of times to assess a number of possible future outcomes, such as the best, worst and mostly likely case scenarios."

My Edit

Shortcomings

1) Traditional DCF models assume we can accurately forecast revenue and earnings 3–5 years into the future. But studies have shown that growth is neither predictable nor persistent.[1]

In other terms, using DCF models is problematic due to the problem of induction, or presupposing that a sequence of events in the future will occur as it always has in the past. Colloquially, in the world of finance, the problem of induction is often simplified with the common phrase: past returns are not indicative of future results. In fact, the SEC demands that all mutual funds use this sentence to warn their investors.[2]

This observation has lead some to conclude that DCF models should only be used to value companies with steady cash flows. For example, DCF models are widely used to value mature companies in stable industry sectors, such as utilities. For industries that are especially unpredictable and thus harder to forecast, DCF models can prove especially challenging.


 * Industry Examples:
 * Real Estate- Investors use DCF models to value commercial real estate development projects. This practice has two main shortcomings. First, the discount rate assumption relies on the market for competing investments at the time of the analysis, which may not persist into the future. Second, assumptions about ten-year income increases are usually based on historic increases in the market rent. Yet the cyclical nature of most real estate markets is not factored in. Most real estate loans are made during boom real estate markets and these markets usually last fewer than ten years. In this case, due to the problem of induction, using a DCF model to value commercial real estate during any but the early years of a boom market can lead to overvaluation.[3]
 * Early-stage Technology Companies- In valuing startups, the DCF method can be applied a number of times, with differing assumptions, to assess a range of possible future outcomes-- such as the best, worst and mostly likely case scenarios. Even so, the lack of historical company data and uncertainty about factors that can affect the company's development make DCF models especially difficult for valuing startups. There is a lack of credibility regarding future cash flows, future cost of capital, and the company's growth rate. By forecasting limited data into an unpredictable future, the problem of induction is especially pronounced.[4]

2) Traditional DCF models assume that the capital asset pricing model can be used to assess the riskiness of an investment and set an appropriate discount rate. But, according to some economists, the capital asset pricing model has been empirically invalidated.[5]

3) Input-output problem


 * DCF is merely a mechanical valuation tool, which makes it subject to the principle "garbage in, garbage out." Small changes in inputs can result in large changes in the value of a company. This is especially the case with terminal values, which make up a large proportion of the Discounted Cash Flow's final value.

4) Doesn't account for all variables


 * Traditional DCF calculations only consider the financial costs and benefits of a decision and do not not fully "capture the short- or long-term importance, value, or risks associated with natural and social capital" because they do not integrate the environmental, social and governance (ESG) performance of an organization. Without a metric for measuring the short and long term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions.